Mutual Funds Vs. Index Funds: What’s The Difference?

If you’re looking for a solid long-term investment, look no further than the US stock market. Over the last 140 years, the stock market has grown at an average annual rate of 9.2%. If you can match that kind of performance, you’re getting a better return than pretty much any other investment.

That said, this only works if your investments are tracking the market as a whole. You can potentially get even higher returns by investing in individual stocks, but that comes along with added risks. With less diverse investments, there’s a higher potential for loss.

In other words, you need to strike a balance. Do you want to take more risks searching for ever higher returns? Or would you prefer a safer, more reliable investment?

Perhaps the two most popular types of investments are mutual funds and index funds. Both types of funds are similar because they’re made up of pools of stock. However, there are important differences that you need to understand before you invest. Here’s a quick overview of mutual funds vs. index funds and why you’d want to choose one over another.

What Is An Index Fund?

An index fund can be either a mutual fund or an exchange-traded fund (ETF). The mutual fund varieties have higher minimum investments, while the ETF varieties can be purchased in smaller dollar amounts.

What separates index funds from other types of funds is the type of investment. Instead of focusing on a particular industry or business sector, an index fund is designed to track the performance of a specific stock index. Various funds track the S&P 500, NASDAQ, the Dow Jones Industrial Average, and other stock indexes. With something like the S&P 500 or NASDAQ, you’re tracking the broader US stock market.

As a result, index funds are well-suited for conservative investors who are willing to sacrifice upside potential for reliability. They’re also great if you don’t have time to follow financial news and want to invest some money passively.

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How Do Index Funds Work?

Traditional funds are run by active managers, who try to strategically buy and sell individual stocks to maximize gains. An index fund manager, on the other hand, is passive. Instead of maximizing gains on any individual trade, they build a portfolio that matches a particular stock index. So if that index consists of 4% small-cap biotech stocks, the manager will try to maintain a 4% proportion of small-cap biotech stocks in their fund.

In this way, an index fund manager tries to match the performance of whatever index they’re tracking. If the index goes up by 7 or 8%, so should the fund.

The most popular index funds in the US track the S&P 500, but that’s far from your only option. There are funds for many other indexes, including:

• Bloomberg U.S. Aggregate Bond Index (tracks the entire US bond market)

• Dow Jones Industrial Average (tracks 30 of the largest US companies)

• Nasdaq Composite Index (tracks 3,000 Nasdaq-traded stocks)

• Wilshire 5000 Total Market Index (tracks the broader US equities market)

• MSCI EAFE Index (tracks a collection of European, Asian, and Australian stocks)

Pros Of Index Funds

Index funds have several benefits, including:

• Diverse investments – Funds that are tied to broad indexes will spread your investments across several sectors, reducing your risk.

• Lower cost – Index funds are much cheaper to manage than actively managed funds, because the company doesn’t have to employ as many analysts and advisors. As a result, the management fees are lower, and you get to keep more of your gains.

• Potentially better performance – Even the best active fund managers sometimes make mistakes. As a matter of fact, the majority of actively-managed funds underperform the S&P 500 in any given year.

• No expertise required – Index funds are simple and straightforward enough that even complete financial novices can understand them.

• Less tax liability – Index-based mutual funds have less turnover than other types of mutual fund, so there’s less tax liability. For index-based ETFs, there’s no liability at all due to turnover.

Cons Of Index Funds

Every type of investment has its drawbacks, and index funds are no exception. Here are some drawbacks to investing in an index fund:

• Returns won’t exceed the broader market – An index fund returns a return that’s based on the average of all the stocks it holds. At least some of those stocks are bound to go down, which limits the overall returns.

• You don’t get to choose your investments – You’re investing in all the stocks on the index, even if you don’t want to invest in a particular company.

• Limited short-term gains – Since the market as a whole tends to move slowly, you’re not likely to see massive returns in the short term.

• Not all indexes perform well – Some indexes only focus on certain sectors of the economy. Funds that track these indexes are more vulnerable to setbacks in a particular sector.

Example Of An Index Fund

One of the most popular index funds is also the oldest. The Vanguard 500 Index Fund was established in 1976 and tracks the S&P 500 index. It has an average annual return of 7.84%, virtually identical to the S&P 500’s 7.86% annual growth rate over that time.

What Is A Mutual Fund?

A mutual fund is an investment mechanism where groups of investors pool their money to share the same investment. The fund, meanwhile, employs money managers who decide how to invest the money. As a result, choosing the best mutual fund is often a matter of finding the best money manager.

The money manager buys and sells stocks, bonds, and other securities and tries to maximize the fund’s gains.

How Do Mutual Funds Work?

When you invest in a mutual fund, you’re buying a portion of the actual fund itself and all its assets. This allows you to earn money in a few different ways:

• If the fund’s assets grow in value, the value of the fund itself goes up. Investors can then cash in by selling their shares in the fund.

• If the fund sells stocks for a profit, it earns a capital gain. In most cases, these capital gains are distributed to investors on an annual basis. Investors can choose to reinvest their distribution in the fund, or receive a check for the same dollar amount.

• Any stock dividends or bond interest payments earned by the fund are also distributed to investors.

A mutual fund works much like a corporation, with the fund manager acting as CEO. The fund manager is answerable to a board of directors, normally comprised of the fund’s largest investors. In addition to the fund manager, larger mutual funds will employ a team of analysts to perform market research and identify opportunities. And like any financial organization, a mutual fund will also employ an accounting team and a legal team.

Pros Of Mutual Funds

Here are some of the reasons to consider investing in a mutual fund:

• Diversify or target your investments – Different mutual funds have different philosophies, from diverse index funds to more targeted funds that focus on a certain industry.

• Can outperform the market – Depending on your money manager, you can potentially get a much higher return than the market at large. In any given year, you could outperform it by an extreme amount. Keep in mind, though, that on a long enough time scale, few active investors actually beat the market.

• Can be affordable – Index-based mutual funds can cost less to invest in than similar index-based ETFs. That said, an actively managed mutual fund is almost always going to be more expensive.

Cons Of Mutual Funds

Then again, there are also some downsides to mutual funds. Let’s look at a few of them:

• Finding the right fund can be hard – You have to do your research on a number of funds and managers. With an index fund, there’s far less research involved.

• Will probably underperform the market – Despite some stellar years, money managers underperform the market more often than not.

• Capital gains liability – If you get a distribution from your mutual fund, even if you re-invest it in the fund, you’ll be liable for capital gains tax on that distribution.

• Expense ratio could be high – Actively managed funds have to employ a larger staff and a high-paid money manager, all of which cuts into your gains.

• Some funds charge a commission – Many funds charge a commission, or “load” on your investment before you’ve even earned anything. Choose the wrong fund, and you could take a 2% or even 3% haircut.

Example Of A Mutual Fund

The Fidelity Investments Magellan Fund (FMAGX), was first founded in 1963. During the period from 1977 to 1990, under the leadership of Peter Lynch, its assets grew from $18 million to a whopping $14 billion. In the first quarter of ’22, Magellan’s portfolio is worth almost $28 billion, and it continues to slightly outpace the S&P 500.

Difference Between Mutual Funds & Index Funds

So, how are mutual funds and index funds different? Here’s a quick and dirty overview:

• Index funds aim to match the growth of a particular stock index. Mutual funds aim to beat the market at large.

• Index funds are passively managed, with funds allocated to track an index. Mutual funds are actively managed, and buy and sell individual securities with an eye to profit.

• Index funds have an average management fee of 0.09% per year. Mutual funds cost an average of 0.82% per year.

Passive Vs. Active Management

Index funds often use computer algorithms to determine how to allocate investments. Since nobody is actively making any decisions, this is known as passive management. In active management, a human manager decides how investments are allocated.

Investment Objectives

Index funds are meant to mirror a particular index. On the other hand, mutual funds try to outperform the overall market. Different funds will use different strategies; for example, some funds prefer to invest in higher-risk, higher-reward sectors like the tech sector.

Mutual Vs. Index Fund Costs

Because they have to pay a larger staff, mutual funds cost more than index funds. Assuming a $1,000 annual investment and an average rate of return of 7%, the average mutual fund would charge you $15,000 in fees. A comparable index fund would charge only $1,800 over the same period.

Should You Invest In Mutual & Index Funds Actively Or Passively?

Whether a passively- or actively-managed fund is best depends on your goals. If you’re willing to take higher risks for a chance at a higher reward, look for an actively-managed fund. If you prefer a less volatile investment, look for one that’s passively-managed.

Summary

Mutual funds and index funds are both ways to invest in a collection of securities. However, index funds are tied to a particular stock index, while actively-managed mutual funds are designed to beat the market. We should also note that there’s some overlap: passively-managed index funds that are packaged as mutual funds. Deciding between mutual funds vs. index funds comes down to your personal situation, but no matter what your investment needs, at least one of these options will be worth a second look.

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